The new risks in risk reg­u­la­tion

Gulf Times - - COMMENT - By Howard Davies

When I took over re­spon­si­bil­ity for bank­ing su­per­vi­sion in the United King­dom, in 1995, a wise old bird in the Bank of Eng­land (BoE) warned me that I would find it a thank­less task. No news­pa­per ever prints a head­line read­ing “All Lon­don Banks Safe and Sound this Week.” But if a prob­lem oc­curs, it is al­most in­vari­ably seen as a case of su­per­vi­sory fail­ure. Dozy watch­dogs asleep at the wheel are a trope that trips quickly into jour­nal­ists’ cov­er­age.

Reg­u­la­tors are caught in a cross­fire of con­flict­ing ex­pec­ta­tions. Banks want to be left alone, un­less they need help. Con­sumers and their po­lit­i­cal rep­re­sen­ta­tives want reg­u­la­tors to be aware of ev­ery trans­ac­tion, ready to in­ter­vene in real time if any gl­itch oc­curs. In the years run­ning up to the 2008 fi­nan­cial cri­sis, the pen­du­lum swung to­ward the non­in­ter­ven­tion­ist end of the spec­trum. To­day, “in­tru­sive” has a pos­i­tive con­no­ta­tion in the reg­u­la­tory lex­i­con. But the need to strike a sen­si­ble bal­ance re­mains.

The other point my wise old bird made was that the only way to gen­er­ate a pos­i­tive story about reg­u­la­tion was to warn of trou­ble ahead. “Reg­u­la­tors warned to­day that…” is a good lede for the Fi­nan­cial Times or Wall Street Jour­nal. Ed­i­tors get a fris­son of ex­cite­ment from wor­ry­ing their read­ers.

Fi­nan­cial reg­u­la­tors and the in­ter­na­tional fi­nan­cial in­sti­tu­tions have been fol­low­ing that sage ad­vice a lot re­cently. As Wil­liam Coen, the sec­re­tary-gen­eral of the Basel Com­mit­tee, put it at a re­cent con­fer­ence, cit­ing for­mer US Fed­eral Re­serve Chair Ben Ber­nanke, “for those work­ing to keep our fi­nan­cial sys­tem re­silient, the en­emy is for­get­ting.” Coen went on to ar­gue that, “the like­li­hood of a fu­ture fi­nan­cial cri­sis oc­cur­ring only in­creases with time.” I sup­pose one can see what he means, though I won­der about the logic of that for­mu­la­tion.

The Euro­pean Cen­tral Bank has weighed in with more spe­cific con­cerns: “Vul­ner­a­bil­i­ties in fi­nan­cial mar­kets con­tinue to build up amid pock­ets of high val­u­a­tions and com­pressed global risk pre­mia.”

The ECB is par­tic­u­larly con­cerned about the feed­back loop to the eu­ro­zone from trou­ble in other mar­kets. That con­cern cen­tres on as­set man­agers: Euro area in­vest­ment funds are vul­ner­a­ble to “po­ten­tial shocks in global fi­nan­cial mar­kets.”

The BoE has sim­i­lar con­cerns about the price of risk. On its “Bank Un­der­ground” blog, which is fast be­com­ing the most in­ter­est­ing of the BoE’s pub­li­ca­tions, you can find anal­y­sis of the evo­lu­tion of risk pre­mia. Us­ing the prices of credit de­fault swaps, it shows that in­vestors are ac­cept­ing less com­pen­sa­tion for bear­ing given amounts of credit risk: com­pen­sa­tion per unit of de­fault risk has fallen by 20% since early 2016. Sim­i­larly, the volatil­ity pre­mium, de­fined as the price of op­tions that in­sure against falls in the eq­uity in­dex, has fallen con­sid­er­ably. In ret­ro­spect, mis­pric­ing of risk was a flash­ing red warn­ing sign that reg­u­la­tors and in­vestors ig­nored in the run up to the 2008 cri­sis.

The In­ter­na­tional Mon­e­tary Fund has got­ten in on the act, too. Even though its Oc­to­ber World Eco­nomic Out­look presents a pos­i­tive pic­ture of global growth, the IMF, no doubt still con­scious of the Pan­glos­sian view it of­fered in 2006, now warns that the world econ­omy is “vul­ner­a­ble to a sud­den tight­en­ing of fi­nan­cial con­di­tions” and that “eq­uity val­u­a­tions ap­pear stretched in some mar­kets.”

In this con­text, “some” is IMF code for the United States. The US mar­ket’s share of global eq­uity val­u­a­tions is the high­est it has ever been – a re­mark­able statis­tic given the de­clin­ing US share of global eco­nomic ac­tiv­ity.

How should we view all these warn­ings? Are the reg­u­la­tors gen­uinely anx­ious, or just cov­er­ing their backs? The re­ceived wis­dom among reg­u­la­tors is that they are bet­ter off be­ing able to say, “We told you so” if some­thing goes wrong, and that there is lit­tle down­side in oc­ca­sion­ally is­su­ing dark warn­ings. Jour­nal­ists rarely look back to check whether the dire out­comes the au­thor­i­ties pointed to ac­tu­ally came to pass. And even if they do check, reg­u­la­tors can al­ways claim that the worst was avoided pre­cisely be­cause they had warned of the risk.

But the warn­ing quo­tient has been ris­ing in re­cent weeks. Should we be gen­uinely anx­ious, and be­gin bat­ten­ing down the hatches to pre­pare for a com­ing storm?

It is hard to be sure, of course, but rea­sons to stay awake at night are mul­ti­ply­ing. While each emerg­ing-mar­ket trou­ble spot – Venezuela, Brazil, Ar­gentina – has idio­syn­cratic fea­tures, a pat­tern is start­ing to emerge. A ris­ing dol­lar, and an in­vest­ment flight to the US, is ac­cen­tu­at­ing these coun­tries’ self-gen­er­ated prob­lems. And while the Fed’s in­ter­est-rate hikes could hardly have been more care­fully sig­nalled in ad­vance, there are still con­cerns that the de­sired fi­nan­cial tight­en­ing in credit mar­kets has scarcely oc­curred yet, and that, if and when it does, some bor­row­ers could find them­selves un­com­fort­ably ex­posed.

Then there is the risk of a trade war. The World Trade Or­gan­i­sa­tion has – at last – warned that an in­ten­si­fied tar­iff war could re­sult in a sharp de­cline in trade. That would be a se­ri­ous blow to the Chi­nese econ­omy, which is al­ready slow­ing markedly for other rea­sons.

So the global eco­nomic risks now seem to be weighted on the down­side, af­ter a be­nign pe­riod. The one piece of good news is that if a re­ces­sion (or per­haps more likely a pe­riod of be­low-trend growth) is in the off­ing, banks are sig­nif­i­cantly more strongly cap­i­talised than they were the last time. We can, how­ever, be less cer­tain about the shadow bank­ing sec­tor, al­most by def­i­ni­tion. We may be about to dis­cover whether the new credit cre­ators, some of whom do not have to live un­der a rig­or­ous regime of cap­i­tal reg­u­la­tion, have priced risk cor­rectly. – Project Syn­di­cate

Howard Davies is Chair­man of the Royal Bank of Scot­land.

Bank of Eng­land head­quar­ters.

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